How Service Providers Buy Your Business

Even if internal costs are lower than outsourcing, as is often the situation when an “apples to apples” case is made, the comparison may be distorted by a common vendor tactic. Outsourcing vendors sometimes “buy the business” by offering very favorable rates for the first few years of a contract and making up for the loss of profits throughout the rest of the relationship.

This tactic may be supported by excess capacity that the vendor can afford to sell (for a short duration) below full costs. Or the vendor may be generating sufficient profits from other companies to afford a loss for a period.

Neither enabling factor lasts for long. In the long run, this leads to higher costs, even in discounted-present-value terms, since entrepreneurs will always find ways to be compensated for taking such risks.

A similar trick is pricing basic services at or below costs and then making up the profits on add-on business.

In an all-too-typical case, a vendor won the outsourcing contract for an entire IT function of a consumer-products company based on an attractive base price. Its price for basic services was unprofitable; it took the deal in the hope of gaining very profitable add-on business for new projects.

As it turned out, the company saved money only for the first year, until requirements changed and the add-ons began. Then, clients began to feel that every problem brought to IT became a new project that demanded incremental funding at rates far higher than internal costs.

One unfortunate effect was that clients shied away from even obvious investments. For example, they found themselves using office systems that were so old that the software vendors no longer supported them, since it appeared too expensive to upgrade to modern, supported packages.

When the company faced the need for austerity, new projects dried up and the vendor found itself saddled with an unprofitable contract. Vendors may “buy the business,” but they won’t lose money. To maintain its margins, the vendor assigned less experienced people to the relationship. Of course, performance suffered; and, despite contracted service levels, there was little the client could do.

Tricks that make outsourcing appear less expensive are best countered by demanding a comparison of all costs over a longer period of time. Costs should include all activities of the function, itemized in a way that permits comparisons under different scenarios, forecasting increased and decreased demands.

The term need not be limited to the initial proposed contract. A longer timeframe is justifiable, since an outsourcing decision is difficult to reverse. It takes years to rebuild an internal capability and transition competencies from a vendor back to staff. Thus, it makes sense to ask vendors to commit to prices for 10 or more years, well beyond the actual terms of the contract.